Great blog posts about macroeconomics

The Solow Growth Model Revisited

If I’ve learned anything from my Economics major so far, it’s that appearances are everything and our models are simplifications of reality. In this post, I’m going to investigate this second point: can the Solow Growth Model be used to accurately describe reality? Further, can the developed world employ this simplified model to alleviate poverty in third world countries?

The Solow Growth Model is a widely held view of the mechanics of long-term economic growth (You can find more in-depth descriptions of the concepts of the Solow Growth Model here and here). It utilizes the production function, Y= F(L,K), in order to make its predictions (L is the economy’s level of labor and K is the economy’s capital level). Namely, it states that an economy cannot have unlimited economic growth, and that based on its entire collection of resources, each economy experiences a steady-state equilibrium output level. In class, we focused mainly on capital accumulation and savings as the vehicle for economic growth in this model. However, I’m curious about what would happen if the model didn’t begin with the production function Y= F(L,K) and instead left all the variables open to change with the classic production function Y= aF(L,K,N,H). I am especially interested in how drastically changes in a and H would affect economic growth.

As we learned from class discussion of the Solow Model, underdeveloped countries tend to experience huge catch-up effects as compared to developed countries when it comes to economic growth. Obviously this rings true in the cases of China, Japan, Germany, and other such “growth miracles” throughout the 20th century. However, the Solow Model fails to explain modern cases such as Kenya and the Democratic Republic of the Congo where quality of life hasn’t markedly increased, even though massive amounts of aid have flooded those economies. No doubt some of those funds have channeled into the accumulation of capital, so why haven’t these countries experienced massive gains in GDP and living standards?

Opinions abound on the proper way to provide for economic growth in developing countries. The Freakonomics podcast tackles this topic in one of their posts from last November. In it, Dean Karlan and Richard Thayler discuss an interesting novel approach taken to attack poverty and encourage growth in undeveloped countries, specifically in Kenya. They explain that many economists believe the best way to help these countries is through providing assets that generate income.

However, a new charity called GiveDirectly is directly providing its beneficiaries with cold, hard cash (usually $1,000, which is a year or two’s income for the average Kenyan) in the form of electronic payments to use at their discretion. The founders, who started the charity during their time as Harvard and MIT graduate school students, were displeased with the status quo of anti-poverty aid. They thought the current aid organizations weren’t reaching the very poorest people and that imposing stipulations onto the usage of aid was creating too much of a burden and inconvenience in the lives of the beneficiaries. It seems the founders believe in the innate goodness of people to use the money on things to help improve living standards.

When I heard about GiveDirectly, I thought of a million logistical problems this company is probably going to face moving forward: Who has a cell phone in Kenya to receive these electronic payments? Won’t people spend all the money on drugs and alcohol? How does GiveDirectly figure out exactly who gets the money? Surprisingly, on its website GiveDirectly heads off these and many other questions on its FAQ page, explaining the tenets behind the charity, explaining its money allocation methodologies, and even providing links to studies rationalizing their practices.

The company’s intentions seem undoubtedly pure, but pure intentions won’t bring Kenya out of oppressive poverty. With the Solow model in mind, will GiveDirectly, and other cash transfer charities to follow, actually provide for substantially higher equilibrium output levels for Kenya? My vote: no. Even assuming that recipients do not misuse their funds on items like drugs and alcohol (as GiveDirectly claims), the fact remains (and Thaler argues this is the Freakonomics podcast on GiveDirectly) that many people living in horribly impoverished countries simply lack the education on how to pull themselves up from the third to the first world. Sure, minute improvements in living conditions and nutrition are sure to occur as a result of GiveDirectly payments (slightly increasing capital and in turn equilibrium output), but if people are unaware of how to improve their lives and their country, I don’t see any sort of marked change occurring in output as a result of cash transfers. Such a policy, providing cash on a micro level, won’t teach the manufacturing sector how to use resources more efficiently (which would be an increase in “a”) and on its own won’t increase human capital either (which would be an increase in “H”).

Unfortunately, to bolster the long-run output of a country like Kenya, GiveDirectly and other cash transfer assets like it won’t do the job. It’s a poverty-aid system with absolutely benevolent intentions, but the Solow Growth Model seems to suggest that any boosts that micro-level cash transfers may have on the inputs of an economy’s production function would not be large enough to impart long-run increases in output. As of yet, there are no miracles on the horizon for Kenya.

Could the case be made that countries like Kenya and the Congo haven’t experienced growth because of the lack of human capital and education, and lack of N, natural resources? Or is it simply they haven’t had the chance to truly grow because they do not have any physical capital for the people to use and grow?